Transfer pricing adjustments and DPT review periods

The recent decision of the FTT in Vitol and the immediate government response announced in the Autumn Budget highlight the difficult interaction between diverted profits tax (DPT) and transfer pricing (TP): Vitol Aviation v HMRC [2021] UKFTT 0353. The case also highlights the importance of considering all strategic options in an active enquiry case in the context of TP / DPT including domestic TP litigation alongside the other options generally available to a taxpayer (such as settling or applying for mutual agreement procedure (MAP)).

In moving so quickly to reverse the effect of the Vitol decision, the Budget announcements suggest that HMRC will continue to aggressively utilise DPT as a “stick” to ensure that taxpayers actively consider their TP arrangements and declare adjustments where appropriate.

In this context, it is worth noting that it is understood that HMRC have recently embarked on a further round of prompting businesses to register for the Profit Diversion Compliance Facility (PDCF). The new round of "nudge letters" provide, in the right circumstances, an opportunity to engage with HMRC to provide tax certainty on a range of transfer pricing and related tax issues. The disclosure facility was introduced in 2019 for MNEs with cross-border arrangements which might be viewed as targeted by the DPT legislation or having TP arrangements inconsistent with the OECD Guidelines. HMRC intended this facility as a method of encouraging MNEs to bring their tax affairs up to date, without risk of investigation by HMRC if full and accurate disclosure is made.

DPT

DPT was introduced in 2015 to prevent the avoidance of UK tax by multinationals operating in the UK by deterring and counteracting activities that divert profits from the UK to low or no tax jurisdictions. DPT is imposed at a penal rate currently set at 25% on diverted profits but which is set to increase to 31% from April 2023. Where the TP structure involves an entity in a low or no tax jurisdiction, it is common for taxpayers to have to manage a corporation tax (CT) enquiry in parallel with a DPT enquiry for the same period, where the common concern for both enquiries is a TP matter. If a DPT charging notice is issued, the taxpayer is required to pay the DPT upon HMRC issuing a charging notice and then engage with HMRC to agree on the appropriate amount of diverted profits during a 15 month review period.

Taxpayers are often incentivised to provide a vast amount and range of information requested by HMRC to first avoid a DPT charging notice, and, following a DPT charging notice, to avoid the adjustments being subject to the higher penal rate of tax. For many taxpayers that provide substantial information to HMRC, often the outcome of a DPT review can be the calculation of diverted profits which are treated as a TP adjustment to be made for CT purposes.

The Vitol case

The Vitol case concerned an application by a taxpayer to the Tribunal to require HMRC to issue a closure notice in relation to open CT periods, regarding the application of UK transfer pricing and permanent establishment legislation on the services supplied by certain UK entities within the Vitol Group to a related party based in Switzerland.

Prior to 2016, an advance pricing agreement (APA) existed between Vitol and HMRC concerning the transfer pricing of these services. However, in the course of seeking to negotiate a new APA, disagreements arose between HMRC and Vitol leading to a CT enquiry by HMRC into Vitol’s returns for 2016 to 2018. In addition, HMRC also issued DPT notices in respect of the periods 2016 and 2017. The review period for these notices was still open, not ending until December 2021 for the 2017 charging notices and May 2022 for the 2016 charging notices. It is worth noting that Vitol had contended that the CT enquiries and the DPT notices all concerned the same TP issue and nothing else, and that HMRC did not dispute this contention.

By November 2020, HMRC had, in essence, proposed a method for determining the dispute following the provision of information by Vitol. Although there were still a number of outstanding requests for information by HMRC to Vitol at this stage, HMRC agreed that these would merely have allowed them to calculate the proposed TP adjustment more precisely and would not have altered the overall conclusions which HMRC had reached as to the relevant matters under enquiry. Indeed, HMRC’s officer at the hearing admitted that by November 2020 HMRC had in fact made an informed decision on which the enquiries would have been settled if Vitol had agreed the position and were in a position to close the enquiry.

It appears key to Vitol in this case that they did not agree with HMRC’s proposed method of determining the TP adjustment, and that without a closure notice being issued by HMRC, they were unable to appeal the TP adjustment to the Tribunal or engage the mutual agreement procedure (MAP) in the UK-Switzerland double taxation treaty.

In these circumstances, Vitol sought to require HMRC to issue closure notices in respect of its CT returns under FA 1998 Sch 18 para 33. HMRC’s response to this application was, essentially, that it had reasonable grounds for refusing to issue a closure notice either because Vitol had not provided all the information reasonably requested or, alternatively, the review period for DPT purposes into Vitol’s position was still open.

HMRC’s first argument was that Vitol had not provided information reasonably requested by HMRC and required for HMRC to arrive at conclusions needed to formulate the closure notices.

The key piece of outstanding information from HMRC’s perspective, the “Spreadsheets”, was said to be necessary to check certain assumptions underlying the TP model on one hand (which HMRC admitted would not have changed the overall conclusions of its November 2020 proposal), but was also said could be used by HMRC to construct a further alternative TP model on the other hand (which indicates that HMRC may have considered alternative conclusions from those in its November 2020 proposal, if it could not reach an agreement with Vitol). The Tribunal dismissed HMRC’s argument by concluding that HMRC were in a position where they had made an informed decision as to the relevant matters under the enquiry, by virtue of the proposal it set out in November 2020 with a basis on which amendments could be made to the relevant returns.

HMRC’s second argument was that issue of closure notices would pre-empt the end of the DPT review periods. One of aspects to this argument was that HMRC viewed that it is up to the taxpayer to utilise the 12 month window provided by the DPT legislation to amend its CT return to make “full transfer pricing adjustments” in order to reduce the DPT charge. Indeed, INTM489988 states that where an open CT enquiry covers the same arrangements as a DPT notice then “in the absence of a customer amendment during an enquiry, HMRC will not generally issue a full closure notice”. From HMRC’s perspective, the policy behind the legislation made it clear that it was within the power of the taxpayer to take action to bring profits within the scope of CT rather than DPT, and that this was to incentivise taxpayers to make voluntary adjustments to diverted profits by amending their TP.

However, despite HMRC’s view on the intended effect of the DPT legislation, the Tribunal noted that the Economic Secretary to the Treasury, Mel Stride MP, had made the following comments in Committee debates: “When DPT is charged, companies are required to pay up front before they can lodge a dispute with HMRC during the DPT review period. DPT incentivises companies to agree adjustments to their CT return during the DPT review period and thus pay the correct amount of corporation tax on their diverted profits, thereby removing such profits from the DPT charged.” The Tribunal noted that the purpose of the legislation was to ensure that “the correct amount of corporation tax” was paid on diverted profits. As such, and since the Tribunal considered that in this case HMRC had established what it considered to be the correct amount of CT to be paid on the profits in dispute, the purpose of the DPT legislation would be satisfied if the closure notice was issued. The issue of a closure notice would not be contrary to the purpose of the legislation, but rather entirely in line with it.

Moreover, while HMRC also claimed that the only reason the taxpayer had requested the closure notice was to ensure that they were subject to CT rather than DPT (and therefore would be subject to the 19% CT rate rather than the 25% DPT rate), the Tribunal noted that the taxpayer’s purpose in requesting the closure notice was irrelevant. The relevant legislation in relation to the issue of closure notices simply required the Tribunal to decide whether HMRC had reasonable grounds for refusing to issue a closure notice in these particular circumstances. As the Tribunal dismissed the two grounds put forward by HMRC, it was concluded that HMRC should issue a closure notice, regardless of the fact that a DPT review period was still open in relation to those same amounts.

Budget announcements

There was good news and bad news on DPT in the Autumn Budget.

Firstly, the government announced that it would, in effect, legislate with immediate effect to reverse the effect of the Vitol decision. A new section will be introduced which provides that where a taxpayer has received a charging notice for DPT for an accounting period and the 15 month review period has not ended, HMRC will not issue a final or partial closure notice in relation to the CT return and the taxpayer cannot apply for a Tribunal direction for HMRC to issue a closure notice until the review period has ended. This change directly targets the decision in the Vitol case and will legislate for HMRC’s preferred view as to how DPT review periods and CT enquiries were intended to operate, with the onus clearly on the taxpayer to put forward a TP adjustment in order to convert any potential DPT charge into a CT charge. As such, a taxpayer will no longer be able to shift the onus onto HMRC to issue a closure notice by using the para 33 process, thereby removing the assessed amounts from the scope of the DPT charge.

However, the government also announced an extension to the period in which taxpayers can amend their CT return to make TP adjustments. The amendment will allow a taxpayer up to 14 months (instead of 12 months under the current rules) of the review period following the issuance of a DPT charging notice to amend their CT return by making a TP adjustment to reduce the amount of DPT due. This means the amount is not taxed at the DPT penal rate and instead is only subject to the CT rate. Again, this change had immediate effect from Budget day.

Taken together, these changes mean that a taxpayer subject to a DPT charging notice will be subject to DPT on the disputed profits unless it amends its CT return within the extended 14 month period of the DPT review.

In addition, the government announced that it would bring DPT within the MAP framework. Where MAP has been used under a double tax treaty to resolve a dispute, legislation will be passed to ensure DPT is one of the taxes to which the outcome of the MAP can apply so that relief can be granted. Although many DPT cases are often concluded as a CT assessment on a transfer pricing basis, as opposed to a DPT assessment, meaning that the assessment is within the scope of MAP, this is still a welcome decision.

Comment

The Vitol decision and the government’s immediate response to it highlight how important a tool DPT and DPT charging notices are to HMRC in dealing with disputed TP adjustments. It is rare for the government to overturn a Tribunal decision quite so quickly and comprehensively as it has in this case.

In our experience, we also consider that it also hints the importance of the interaction between DPT and TP in the context of HMRC’s information gathering procedures for these types of enquiries. DPT has often been a useful tool for HMRC to incentivise taxpayers to be much more transparent and provide comprehensive information over and above what may be requested in a CT enquiry. As can be seen from this case, however, the power of HMRC to use DPT as a “stick” to gather more information can diminish once it is established that the CT and DPT enquiries focus on the same TP issue and nothing else, and once HMRC has reached a stage to make an informed decision on the profits subject to a TP or DPT adjustment.

Another interesting point about this case is that Vitol considered that appealing the TP adjustment to the Tribunal was an option for them (as well as applying for MAP under the relevant treaty). Domestic TP litigation in the UK is still very rare, but this case clearly shows that it is a strategic option worth considering in any enquiry case and how this fits into context of TP/DPT enquiries, alongside the other options generally available (such as settling or applying for MAP).

In summary, the interaction between DPT review periods and open CT enquiries will continue to be a complex area which will depend on the specific facts and circumstances of each taxpayer. Taxpayers will need to carefully navigate the legislation, HMRC guidance and case law to consider their tax management strategy in these situations.